The four basic options trading strategies and risk profiles

I am going to describe the potential risks and rewards associated with the four basic options strategies.

Options are one of the most versatile trading instruments ever invented. They provide a high-leverage approach to trading that can significantly limit the overall risk of a trade, especially when combined with stock or futures. As a result, understanding how to develop profitable strategies using options can be extremely rewarding. The key is to develop an appreciation about how these investment vehicles work, what risks are involved, and the vast reward potential that can be unleashed with well-conceived and time-tested trading strategies.

The four basic strategies that are fundamental to your options trading knowledge are:

Long Call (buying a call)

Short Call (writing a call)

Long Put (buying a put)

Short Put (writing a put)

X-axis – time, Y-axis – security price

I have sourced the information below from The Bible of Options Strategies – The Definitive Guide for Practical Trading Strategies by Guy Cohen. It neatly summarises the graphs above and outlines when you should be looking to use each of the 4 basic options strategies.

1- Buying a Call

Belief that stock will rise (bullish outlook)

Risk limited to premium paid

Unlimited maximum reward

2- Writing a Call

Belief that stock will fall (bearish outlook)

Maximum reward limited to premium received

Risk potentially unlimited (as stock price rises)

Can be combined with another position to limit the risk

3- Buying a Put

Belief that stock will fall (bearish outlook)

Risk limited to premium paid

Unlimited maximum reward up to the strike price less the premium paid

4 -Writing a Put

Belief that stock will rise (bullish outlook)

Risk “unlimited” to a maximum equating to the strike price less the premium received

Maximum reward limited to the premium received

Can be combined with another position to limit the risk

The four options strategies and the time decay of options
Using the above information and some basic knowledge of option pricing we can make decisions about maximising profit from the use of a combined options strategy. For example, an option has a greater value to the buyer with more time left to expiry as there is more chance that the option will be able to be exercised to yield a profit for the buyer.

There is a rule when trading options known as the ‘rule of opposites’ where if one thing isn’t true, then the opposite must be true. Thus, we can say that when options are reducing in time to expiry (increasing time decay), it is a good time for selling options and bad for buying options the closer you get to the expiry time.

Since the value of an option significantly decreases during the last month to expiration, a strong options strategy is not to own such time decayed options but rather to sell them.

Using the strategies above, we would buy calls and puts with at least three months (or more) left to expiration, thereby looking for the options to increase in
value during that time. Similarly, we would short calls and puts with a month or less to expiration, thereby looking for short-term income as the option hopefully expires worthless.